Chapter 14
Multinational Capital Budgeting
Lecture Outline
Subsidiary versus Parent Perspective
Tax Differentials
Input for Multinational Capital Budgeting
Multinational Capital Budgeting Example
Background
Analysis
Other Factors to Consider
Exchange Rate Fluctuations
Inflation
Adjusting Project Assessment for Risk
Risk-Adjusted Discount Rate
Sensitivity Analysis
Simulation
2 Multinational Capital Budgeting
Chapter Theme
This chapter identifies additional considerations in multinational capital budgeting versus domestic
capital budgeting. These considerations can either be explained briefly or illustrated with the use of an
example.
Topics to Stimulate Class Discussion
1. Create an idea for a firm to expand its operations overseas. Provide the industry of the firm. Given
this information, students should be requested to list all information that needs to be gathered in
order to conduct a capital budgeting analysis.
POINT/COUNTER-POINT
Should MNCs Use Forward Rates to Estimate Dollar Cash Flows of Foreign
Projects?
COUNTER-POINT: No. An MNC should use its own forecasts for each year in which it will receive net
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: An MNC should only use the forward rate in place of its expectations if it plans to hedge its
Answers to End of Chapter Questions
1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed from
the parent’s perspective? What additional factors that normally are not relevant for a purely domestic
project deserve consideration in multinational capital budgeting?
Multinational Capital Budgeting 3
ANSWER: When a parent allocates funds for a project, it should view the project’s feasibility from
2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the capital
budgeting analysis?
List the various techniques for adjusting risk in multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
Explain how simulation can be used in multinational capital budgeting. What can it do that other risk
adjustment techniques cannot?
ANSWER: Point estimates of exchange rates lead to a point estimate of a project’s NPV. It is more
3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter,
explain the sources of uncertainty surrounding a proposed project in Hungary by a U.S. firm. In what
ways is the estimated net present value of this project more uncertain than that of a similar project in
a more developed European country?
ANSWER: The estimated NPV is more uncertain because cash flows are more uncertain. The high
4. Accounting for Risk. Your employees have estimated the net present value of project X to be $1.2
million. Their report says that they have not accounted for risk, but that with such a large NPV, the
project should be accepted since even a risk-adjusted NPV would likely be positive. You have the
final decision as to whether to accept or reject the project. What is your decision?
ANSWER: The decision should not be made until risk has been considered. If the project has a risk
4 Multinational Capital Budgeting
5. Impact of Exchange Rates on NPV. a) Describe in general terms how future appreciation of the
euro will likely affect the value (from the parent’s perspective) of a project established in Germany
today by a U.S.-based MNC. Will the sensitivity of the project value be affected by the percentage
of earnings remitted to the parent each year?
ANSWER:
a. Future appreciation of the euro would benefit the parent since the euro earnings would be worth
6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity of
the net present value to exchange rate forecasts.
ANSWER: By financing the project with the same currency that is received from the project, the
7. September 11 Effects on NPV. In August 2001, Woodsen Inc. of Pittsburgh, PA considered the
development of a large subsidiary in Greece. In response to the September 11, 2001 terrorist attack
on the U.S., its expected cash flows and earnings from this acquisition were reduced only slightly.
Yet, the firm decided to retract its offer because of an increase in its required rate of return on the
project, which caused the NPV to be negative. Explain why the required rate of return on its project
may have increased after the attack.
ANSWER: Its cash flows were subject to more uncertainty, because the full economic effects of the
8. Assessing a Foreign Project. Huskie Industries, a U.S.-based MNC, considers purchasing a small
manufacturing company in France that sells products only within France. Huskie has no other
existing business in France and no cash flows in euros. Would the proposed acquisition likely be
more feasible if the euro is expected to appreciate or depreciate over the long run? Explain.
ANSWER: The proposed acquisition is likely to be more feasible if the euro is expected to
9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered
establishing a theme park in France, were the forecasted revenues and costs associated with the
Multinational Capital Budgeting 5
French park sufficient to assess the feasibility of this project? Were there any other ―relevant cash
flows‖ that deserved to be considered?
ANSWER: Other relevant cash flows are Walt Disney World’s existing cash flows. The
10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was
independent of its operations in the United States. The subsidiary’s performance was well above
what was expected. Consequently, when a British firm approached Athens about the possibility of
acquiring the subsidiary, Athens’ chief financial officer implied that the subsidiary was performing
so well that it was not for sale. Comment on this strategy.
ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price
11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing
below the cash flow projections developed before the subsidiary was established. Lehigh anticipated
that future cash flows would also be lower than the original cash flow projections. Consequently,
Lehigh decided to inform several potential acquiring firms of its plan to sell the subsidiary. Lehigh
then received a few bids. Even the highest bid was very low, but Lehigh accepted the offer. It
justified its decision by stating that any existing project whose cash flows are not sufficient to
recover the initial investment should be divested. Comment on this statement.
12. Impact of Reinvested Foreign Earnings on NPV. Flagstaff Corp. is a U.S.-based firm with a
subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the next
10 years since the interest rate earned on these securities is so high. Then, after 10 years, it will
remit all accumulated earnings to the United States. What is a drawback of using this approach?
(Assume the securities have no default or interest rate risk.)
ANSWER: While the funds are reinvested at high rates, they may be worth less dollars ten years
13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The
construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years.
During the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi,
and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted
back to the parent at the end of each year. At the end of the third year, Brower expects to sell the
plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700
cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.
6 Multinational Capital Budgeting
a. Determine the NPV for this project. Should Brower build the plant?
ANSWER:
Cash Flows:
b. How would your answer change if the value of the cedi was expected to remain unchanged from
its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should Brower
construct the plant then?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar
over the course of the three years:
14. Impact of Financing on NPV. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiary in
Japan. It is very confident that the Japanese yen will appreciate against the dollar over time. The
subsidiary will retain only enough revenue to cover expenses and will remit the rest to the parent
each year. Will Ventura benefit more from exchange rate effects if its parent provides equity
financing for the subsidiary or if the subsidiary is financed by local banks in Japan? Explain.
Multinational Capital Budgeting 7
ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity
15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering
establishing a consumer products division in Germany, which would be financed by German banks.
Santa Monica completed its capital budgeting analysis in August. Then, in November, the
government leadership stabilized and political conditions improved in Germany. In response, Santa
Monica increased its expected cash flows by 20 percent but did not adjust the discount rate applied to
the project. Should the discount rate be affected by the change in political conditions?
ANSWER: The risk may have declined if there is less uncertainty surrounding cash flows. However,
16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign
investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume that
several MNCs are likely to consider DFI in this country. The inflation rate in recent years has
averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about $5
per hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting analysis
for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent increase for each
of the next 10 years. The components produced are to be exported to Piedmont’s headquarters in the
United States, where they will be used in the production of computers. Do you think Piedmont will
overestimate or underestimate the net present value of this project? Why? (Assume that LDC’s
currency is tied to the dollar and will remain that way.)
ANSWER: The net present value will likely be overestimated because the labor costs in LDC will
17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for
expansion in Brazil. Brazil offers considerable potential because it has 150 million people and their
demand for soft drinks is increasing. However, the soft drink consumption is still only about one-fifth
of the soft drink consumption in the U.S. PepsiCo’s initial outlay was used to purchase three
production plants and a distribution network of almost 1,000 trucks to distribute its products to retail
stores in Brazil. The expansion in Brazil was expected to make PepsiCo’s products more accessible to
Brazilian consumers.
a. Given that PepsiCo’s investment in Brazil was entirely in dollars, describe its exposure to
exchange rate risk resulting from the project. Explain how the size of the parent’s initial
8 Multinational Capital Budgeting
investment and the exchange rate risk would have been affected if PepsiCo had financed much of
the investment with loans from banks in Brazil.
ANSWER: As the earnings in Brazil are remitted, they will be converted to dollars. If Brazil’s
b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of the
project in Brazil.
ANSWER: The demand in Brazil for the soft drinks and snacks produced by PepsiCo Inc. is
c. What factors did PepsiCo likely consider in deriving its required rate of return on the project in
Brazil?
ANSWER: PepsiCo planned to use $500 million for investment in Brazil. Its funds may have been
d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective of
the U.S. parent.
ANSWER: There is some uncertainty about the demand for PepsiCo’s products in Brazil, because it
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already
had some existing operations in Brazil. When capital budgeting analysis was used to determine
the feasibility of this project, should the project have been assessed from a Brazil perspective or
a U.S. perspective? Explain.
Multinational Capital Budgeting 9
ANSWER: PepsiCo’s parent uses its own funds to support expansion. Thus, it should make
18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be
financed with U.S. dollars). All cash flows generated from the project were to be reinvested in
Thailand for several years. Explain how the Asian crisis would have affected the expected cash
flows of this project and the required rate of return on this project. If the cash flows were to be
remitted to the U.S. parent, explain how the Asian crisis would have affected the expected cash flows
of this project.
ANSWER: The Asian crisis would have reduced local currency cash flows (due to a weak economy),
19. Tax Effects on NPV. When considering the implementation of a project in one of various possible
countries, what types of tax characteristics should be assessed among the countries? (See the chapter
appendix)
ANSWER: Corporate taxes in the country should be considered by an MNC, along with withholding
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion
South Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion
and 4 billion won in the two years of operation, respectively. The project has no salvage value. The
current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain
constant over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per
U.S. dollar after two years. Further assume that the funds are blocked and that the parent
company will only be able to remit them back to the U.S. in two years. How does this affect the
NPV of the project?
10 Multinational Capital Budgeting
ANSWER:
Year 0 1 2
Investment –2
Operating CF 3 4
ANSWER:
Year 0 2
Investment –2
21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong,
where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that allows
for alternative exchange rate scenarios. Why would Carson use this approach rather than using the
pegged exchange rate as its exchange rate forecast in every year?
22. Decisions Based on Capital Budgeting. Marathon Inc. considers a one-year project with the
Belgian government. Its euro revenue would be guaranteed. Its consultant states that the percentage
change in the euro is represented by a normal distribution, and that based on a 95 percent confidence
interval, the percentage change in the euro is expected to be between 0 percent and 6 percent.
Marathon uses this information to create three scenarios: 0%, 3%, and 6% for the euro. It derives an
estimated NPV based on each scenario, and then determines the mean NPV. The NPV was positive
for the 3% and 6% scenarios, but was slightly negative for the 0 percent scenario. This led Marathon
to reject the project. Its manager stated that it did not want to pursue a project that had a one–in-three
Multinational Capital Budgeting 11
chance of having a negative NPV. Do you agree with the manager’s interpretation of the analysis?
Explain.
ANSWER: Marathon’s interpretation implies that each scenario has the same probability of
23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory in
Brazil, half the initial outlay will be funded by the parent’s equity and half by borrowing funds in
Brazil. Assume that Nike wants to assess the project from its own perspective to determine whether
the project’s future cash flows will provide a sufficient return to the parent to warrant the initial
investment. Why will the estimated cash flows be different from the estimated cash flows of Nike’s
shoe factory in New Hampshire? Why will the initial outlay be different? Explain how Nike can
conduct multinational capital budgeting in a manner that will achieve its objective.
ANSWER: The net cash flows to the parent will be different because they are based on the revenue
Advanced Questions
24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the
project will generate total operating cash flows of $3,500,000, measured in today’s dollars using a
required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:
25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it can
capitalize on its technology. It is risk-averse, but is attracted to the project because of a government
guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand
government at the end of the year. The payment by the New Zealand government is also guaranteed
by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and
12 Multinational Capital Budgeting
remitted to the parent in one year. The prevailing nominal one-year interest rate in New Zealand is
5% while the nominal one-year interest rate in the U.S. is 9%. Zistine’s chief executive officer
believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his
best guess is that the change in its value will be in accordance with the international Fisher effect. He
also believes that interest rate parity holds. He provides this information to three recent finance
graduates that he just hired as managers and asks them for their input.
a. The first manager states that due to the parity conditions, the feasibility of the project will be the
same whether the cash flows are hedged with a forward contract or are not hedged. Is this
manager correct? Explain.
b. The second manager states that the project should not be hedged. Based on the interest rates, the
IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the
project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a
premium, and therefore the forward rate will generate more U.S. dollar cash flows than the
expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct?
Explain.
ANSWER:
a. The first manager is wrong. The project is more feasible if it hedges, because the expected dollar
26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the
use of its technology to firms in Mexico. It already has received orders from Mexican firms that will
generate MXP3,000,000 in revenue at the end of the next year. However, it might also receive a
contract to provide this technology to the Mexican government. In this case, it will generate a total of
MXP5,000,000 at the end of the next year. It will not know whether it will receive the government
order until the end of the year.
Today’s spot rate of the peso is $.14. The one-year forward rate is $.12. Blustream expects that the
spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to
cover development expenses (regardless of whether the Mexican government purchases the
technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent.
Multinational Capital Budgeting 13
Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive
from the project.
a. Determine the NPV if Blustream receives the government contract.
ANSWER:
b. If Blustream does not receive the contract, it will have hedged more than it needed to and will
offset the excess forward sales by purchasing pesos in the spot market at the time the forward
sale is executed. Determine the NPV of the project assuming that Blustream does not receive the
government contract.
ANSWER:
Revenue converted to $: MXP3,000,000 × $.12 = $360,000
c. Now consider an alternative strategy in which Blustream only hedges the minimum peso revenue
that it will receive. In this case, any revenue due to the government contract would not be
hedged. Determine the NPV based on this alternative strategy and assume that Blustream
receives the government contract.
Revenue converted to $:
14 Multinational Capital Budgeting
d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it will
receive, determine the NPV assuming that it does not receive the government contract.
Revenue converted to $:
e. If there is a 50 percent chance that Blustream will receive the government contract, would you
advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may
receive? Explain.
f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum
amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging
the minimum amount it will receive with a forward contract and hedging the additional revenue it
might receive with a put option on Mexican pesos. The one-year put option has an exercise price
of $.125 and a premium of $.01. Determine the NPV if Blustream uses this strategy and receives
the government contract. Also, determine the NPV if Blustream uses this strategy and does not
receive the government contract. Given that there is a 50 percent probability that Blustream will
receive the government contract, would you use this new strategy or the strategy that you
selected in question (e)?
ANSWER:
SCENARIO IF BLUSTREAM RECEIVES GOVERNMENT CONTRACT
SCENARIO IF BLUSTREAM DOES NOT RECEIVE GOVERNMENT CONTRACT
Multinational Capital Budgeting 15
27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand
but is considering establishing a subsidiary there. The following information has been gathered to
assess this project:
The initial investment required is $50 million in New Zealand dollars (NZ$). Given the existing
The project will be terminated at the end of Year 3, when the subsidiary will be sold.
The price, demand, and variable cost of the product in New Zealand are as follows:
Year Price Demand Variable Cost
The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at
the end of Year 2, and $.56 at the end of Year 3.
In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the
existing New Zealand loan. The working capital will not be liquidated but will be used by the
acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52 million after
subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
Wolverine requires a 20 percent rate of return on this project.
16 Multinational Capital Budgeting
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the parent
would invest an additional $10 million to cover the working capital requirements so that the
subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of the
subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this
alternative financing arrangement more feasible for the parent than the original proposal? Explain.
ANSWER: This alternative financing arrangement will have the following effects. First, it will
Multinational Capital Budgeting 17
Capital Budgeting Analysis with an Alternative
Financing Arrangement: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1)×(2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent
invests more of its own funds to cover the working capital? Explain.
ANSWER: The NPV would be more sensitive to exchange rate movements if the parent uses its own
financing to cover the working capital requirements. If it used New Zealand financing, a portion of
18 Multinational Capital Budgeting
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the
end of Year 3. How is the project’s NPV affected?
ANSWER: The effects of the blocked funds are shown below:
Year 1 Year 2 Year 3
13. Net cash flow to subsidiary
=(12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$ 15,920,000
e. What is the break-even salvage value of this project if Wolverine uses the original financing proposal
and funds are not blocked?
First, determine the present value of cash flows when excluding salvage value:
End of Present Value of Cash Flows
Year (excluding salvage value)
1 $ 3,315,000
2 4,050,000